Case Digest: Commissioner of Internal Revenue v. Court of Appeals, 301 SCRA 152, August 29, 1996

Corporation Law | Classification of Shares, Redeemable Shares

Under the Doctrine of Equality of Shares, all stocks issued by the corporation are presumed to be equal with the same privileges and liabilities, provided that the Articles of Incorporation is silent on such differences. 

The most basic classification of shares is: common shares and preferred shares. It was explained that common shares and preferred shares are part of the corporation's capital stock and that both stockholders are no different from ordinary investors who take on the same investment risks. Preferred and common shareholders participate in the same venture, willing to share in the profits and losses of the enterprise.

Reclassification of shares does not always bring any substantial alteration in the subscriber's proportional interest. But the exchange of shares is different - there would be shifting of the balance of stock features like priority in dividend declarations or absence of voting rights. Yet, neither the reclassification nor exchange of shares per se, yields realized income for tax purposes." In this case, certain shares were exchanged for preferred shares but no change in the proportional interest of the shareholder resulted. The Court went on to continue that: "There was no cash flow. Both stocks had the same par value. Under the facts herein, any difference in their market value would be immaterial at the time of exchange because no income is yet realized - it was a mere corporate paper transaction. It would be different, if the exchange transaction resulted into a cash flow of wealth, in which case income tax may be imposed.

Redemption is repurchase or reacquisition of stock by a corporation which issued the stock in  exchange for property, whether or not the acquired share is cancelled, retired or held in the treasury. Essentially, the corporation gets back some of its stock, distributes cash or property to the shareholder in payment of the stock and continues in business as before.

For tax purposes, there are cases when redemption of shares (which were previously issued as stock dividends) is considered a scheme to circumvent the tax consequence  of cash dividends. There are cases when redemption is used as a veil for constructive distribution of cash dividends. In those cases, the amounts received by the shareholder will be treated as cash dividends because the proceeds of redemption in such a case are additional wealth; they are not merely returns of capital but gains thereon.

• In the 1930s, Don Andres Soriano, a citizen and resident of the United States, established A. Soriano Y Cia (predecessor of ANSCOR) with a capital of P1,000,000.00 divided into 10,000 common shares at a par value of P100/share. 
• In 1937, Don Andres subscribed to 4,963 of the 5,000 originally issued shares.
• In 1945, ANSCOR's authorized capital stock increased to P2,500,000.00, with Don Andres subscribed to 14,963 common shares.
• Don Andres transferred 1,250 shares each to his two sons, Jose and Andres, Jr., as their initial investments in ANSCOR. Both sons are foreigners.
• Between 1949 to 1963, ANSCOR declared stock dividends, increasing Don Andres' total shareholdings to 185,154 shares by 1964.
• In 1964, Don Andres Soriano passed away, his wife, Doña Carmen, inherited 92,577 shares, while the other half formed part of his estate.
• In 1966, ANSCOR increased its capital stock to P30M. Stock dividends increased Doña Carmen's and the estate's shareholdings to 138,864 and 138,867 shares, respectively.
• In 1967, Doña Carmen requested a ruling from the United States Internal Revenue Service (IRS) regarding an exchange of common with preferred shares as a tax avoidance scheme.
• In 1968, ANSCOR reclassified existing 300,000 common shares into 150,000 common and 150,000 preferred shares.
• Doña Carmen exchanged her whole 138,864 common shares for 138,860 of the newly reclassified preferred shares based on the IRS ruling.
• The estate of Don Andres in turn, exchanged 11,140 of its common shares, for the remaining 11,140 preferred shares, thus reducing its (the estate) common shares to 127,727.
• ANSCOR redeemed 28,000 common shares from the Don Andres' estate. 
• In November 1968,  ANSCOR's capital stock increased to P75M divided into 150,000 preferred shares and 600,000 common shares. 
• ANSCOR redeemed 80,000 common shares from the Don Andres' estate, further reducing the latter's common shareholdings to 19,727.
• In 1973, ANSCOR faced a deficiency withholding tax-at-source assessment from the Bureau of Internal Revenue (BIR) for the redemptions and exchange of stocks in 1968 and the second quarter of 1969.
• ANSCOR claimed tax amnesty.
• BIR: Ruled the invoked decrees did not cover the sections related to ANSCOR's assessments.
• ANSCOR appealed the tax assessments to the Court of Tax Appeals .
• CTA: Reversed the BIR's ruling based on prima facie evidence.
• Court of Appeals: Affirmed the CTA's decision, upholding ANSCOR's position regarding the tax assessments on the stock exchange and redemption transactions.

WoN ANSCOR's redemption of stocks from its stockholder as well as the exchange of common with preferred shares can be considered as "essentially equivalent to the distribution of taxable dividend" making the proceeds thereof taxable. YES

The bone of contention is the interpretation and application of Section 83(b) of the 1939 Revenue Act 38 which provides:

Sec. 83. Distribution of dividends or assets by corporations. —

(b) Stock dividends — A stock dividend representing the transfer of surplus to capital account shall not be subject to tax. However, if a corporation cancels or redeems stock issued as a dividend at such time and in such manner as to make the distribution and cancellation or redemption, in whole or in part, essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock shall be considered as taxable income to the extent it represents a distribution of earnings or profits accumulated after March first, nineteen hundred and thirteen. (Emphasis supplied)

For the exempting clause of Section, 83(b) to apply, it is indispensable that: (a) there is redemption or cancellation; (b) the transaction involves stock dividends and (c) the "time and manner" of the transaction makes it "essentially equivalent to a distribution of taxable dividends." Of these, the most important is the third.

Redemption is repurchase, a reacquisition of stock by a corporation which issued the stock in exchange for property, whether or not the acquired stock is cancelled, retired or held in the treasury.  Essentially, the corporation gets back some of its stock, distributes cash or property to the shareholder in payment for the stock, and continues in business as before. The redemption of stock dividends previously issued is used as a veil for the constructive distribution of cash dividends. In the instant case, there is no dispute that ANSCOR redeemed shares of stocks from a stockholder (Don Andres) twice (28,000 and 80,000 common shares). But where did the shares redeemed come from? If its source is the original capital subscriptions upon establishment of the corporation or from initial capital investment in an existing enterprise, its redemption to the concurrent value of acquisition may not invite the application of Sec. 83(b) under the 1939 Tax Code, as it is not income but a mere return of capital. On the contrary, if the redeemed shares are from stock dividend declarations other than as initial capital investment, the proceeds of the redemption is additional wealth, for it is not merely a return of capital but a gain thereon.

It is not the stock dividends but the proceeds of its redemption that may be deemed as taxable dividends. Here, it is undisputed that at the time of the last redemption, the original common shares owned by the estate were only 25,247.5 91 This means that from the total of 108,000 shares redeemed from the estate, the balance of 82,752.5 (108,000 less 25,247.5) must have come from stock dividends. Besides, in the absence of evidence to the contrary, the Tax Code presumes that every distribution of corporate property, in whole or in part, is made out of corporate profits such as stock dividends. The capital cannot be distributed in the form of redemption of stock dividends without violating the trust fund doctrine — wherein the capital stock, property and other assets of the corporation are regarded as equity in trust for the payment of the corporate creditors. Once capital, it is always capital.  That doctrine was intended for the protection of corporate creditors. 

With respect to the third requisite, ANSCOR redeemed stock dividends issued just 2 to 3 years earlier. The time alone that lapsed from the issuance to the redemption is not a sufficient indicator to determine taxability. It is a must to consider the factual circumstances as to the manner of both the issuance and the redemption. The "time" element is a factor to show a device to evade tax and the scheme of cancelling or redeeming the same shares is a method usually adopted to accomplish the end sought. Was this transaction used as a "continuing plan," "device" or "artifice" to evade payment of tax? It is necessary to determine the "net effect" of the transaction between the shareholder-income taxpayer and the acquiring (redeeming) corporation. The "net effect" test is not evidence or testimony to be considered; it is rather an inference to be drawn or a conclusion to be reached. It is also important to know whether the issuance of stock dividends was dictated by legitimate business reasons, the presence of which might negate a tax evasion plan.

The issuance of stock dividends and its subsequent redemption must be separate, distinct, and not related, for the redemption to be considered a legitimate tax scheme. Redemption cannot be used as a cloak to distribute corporate earnings. Otherwise, the apparent intention to avoid tax becomes doubtful as the intention to evade becomes manifest. It has been ruled that:

[A]n operation with no business or corporate purpose — is a mere devise which put on the form of a corporate reorganization as a disguise for concealing its real character, and the sole object and accomplishment of which was the consummation of a preconceived plan, not to reorganize a business or any part of a business, but to transfer a parcel of corporate shares to a stockholder. 

Depending on each case, the exempting provision of Sec. 83(b) of the 1939 Code may not be applicable if the redeemed shares were issued with bona fide business purpose, which is judged after each and every step of the transaction have been considered and the whole transaction does not amount to a tax evasion scheme.

ANSCOR invoked two reasons to justify the redemptions — (1) the alleged "filipinization" program and (2) the reduction of foreign exchange remittances in case cash dividends are declared. The Court is not concerned with the wisdom of these purposes but on their relevance to the whole transaction which can be inferred from the outcome thereof. Again, it is the "net effect rather than the motives and plans of the taxpayer or his corporation" that is the fundamental guide in administering Sec. 83(b). This tax provision is aimed at the result.  It also applies even if at the time of the issuance of the stock dividend, there was no intention to redeem it as a means of distributing profit or avoiding tax on dividends. The existence of legitimate business purposes in support of the redemption of stock dividends is immaterial in income taxation. It has no relevance in determining "dividend equivalence". Such purposes may be material only upon the issuance of the stock dividends. The test of taxability under the exempting clause, when it provides "such time and manner" as would make the redemption "essentially equivalent to the distribution of a taxable dividend", is whether the redemption resulted into a flow of wealth. If no wealth is realized from the redemption, there may not be a dividend equivalence treatment. In the metaphor of Eisner v. Macomber, income is not deemed "realize" until the fruit has fallen or been plucked from the tree.

The three elements in the imposition of income tax are: (1) there must be gain or and profit, (2) that the gain or profit is realized or received, actually or constructively,  and (3) it is not exempted by law or treaty from income tax. Any business purpose as to why or how the income was earned by the taxpayer is not a requirement. Income tax is assessed on income received from any property, activity or service that produces the income because the Tax Code stands as an indifferent neutral party on the matter of where income comesfrom. 

As stated above, the test of taxability under the exempting clause of Section 83(b) is, whether income was realized through the redemption of stock dividends. The redemption converts into money the stock dividends which become a realized profit or gain and consequently, the stockholder's separate property. Profits derived from the capital invested cannot escape income tax. As realized income, the proceeds of the redeemed stock dividends can be reached by income taxation regardless of the existence of any business purpose for the redemption. Otherwise, to rule that the said proceeds are exempt from income tax when the redemption is supported by legitimate business reasons would defeat the very purpose of imposing tax on income. Such argument would open the door for income earners not to pay tax so long as the person from whom the income was derived has legitimate business reasons. In other words, the payment of tax under the exempting clause of Section 83(b) would be made to depend not on the income of the taxpayer, but on the business purposes of a third party (the corporation herein) from whom the income was earned. This is absurd, illogical and impractical considering that the Bureau of Internal Revenue (BIR) would be pestered with instances in determining the legitimacy of business reasons that every income earner may interposed. It is not administratively feasible and cannot therefore be allowed.

The ruling in the American cases cited and relied upon by ANSCOR that "the redeemed shares are the equivalent of dividend only if the shares were not issued for genuine business purposes", or the "redeemed shares have been issued by a corporation bona fide"  bears no relevance in determining the non-taxability of the proceeds of redemption ANSCOR, relying heavily and applying said cases, argued that so long as the redemption is supported by valid corporate purposes the proceeds are not subject to tax. The adoption by the courts below  of such argument is misleading if not misplaced. A review of the cited American cases shows that the presence or absence of "genuine business purposes" may be material with respect to the issuance or declaration of stock dividends but not on its subsequent redemption. The issuance and the redemption of stocks are two different transactions. Although the existence of legitimate corporate purposes may justify a corporation's acquisition of its own shares under Section 41 of the Corporation Code, such purposes cannot excuse the stockholder from the effects of taxation arising from the redemption. If the issuance of stock dividends is part of a tax evasion plan and thus, without legitimate business reasons, the redemption becomes suspicious which exempting clause. The substance of the whole transaction, not its form, usually controls the tax consequences. 

The two purposes invoked by ANSCOR, under the facts of this case are no excuse for its tax liability. First, the alleged "filipinization" plan cannot be considered legitimate as it was not implemented until the BIR started making assessments on the proceeds of the redemption. Such corporate plan was not stated in nor supported by any Board Resolution but a mere afterthought interposed by the counsel of ANSCOR. Being a separate entity, the corporation can act only through its Board of Directors. 117 The Board Resolutions authorizing the redemptions state only one purpose — reduction of foreign exchange remittances in case cash dividends are declared. Not even this purpose can be given credence. Records show that despite the existence of enormous corporate profits no cash dividend was ever declared by ANSCOR from 1945 until the BIR started making assessments in the early 1970's. Although a corporation under certain exceptions, has the prerogative when to issue dividends, yet when no cash dividends was issued for about three decades, this circumstance negates the legitimacy of ANSCOR's alleged purposes. Moreover, to issue stock dividends is to increase the shareholdings of ANSCOR's foreign stockholders contrary to its "filipinization" plan. This would also increase rather than reduce their need for foreign exchange remittances in case of cash dividend declaration, considering that ANSCOR is a family corporation where the majority shares at the time of redemptions were held by Don Andres' foreign heirs.

Secondly, assuming arguendo, that those business purposes are legitimate, the same cannot be a valid excuse for the imposition of tax. Otherwise, the taxpayer's liability to pay income tax would be made to depend upon a third person who did not earn the income being taxed. Furthermore, even if the said purposes support the redemption and justify the issuance of stock dividends, the same has no bearing whatsoever on the imposition of the tax herein assessed because the proceeds of the redemption are deemed taxable dividends since it was shown that income was generated therefrom.

Thirdly, ANSCOR argued that to treat as "taxable dividend" the proceeds of the redeemed stock dividends would be to impose on such stock an undisclosed lien and would be extremely unfair to intervening purchase, i.e. those who buys the stock dividends after their issuance. 118 Such argument, however, bears no relevance in this case as no intervening buyer is involved. And even if there is an intervening buyer, it is necessary to look into the factual milieu of the case if income was realized from the transaction. Again, we reiterate that the dividend equivalence test depends on such "time and manner" of the transaction and its net effect. The undisclosed lien 119 may be unfair to a subsequent stock buyer who has no capital interest in the company. But the unfairness may not be true to an original subscriber like Don Andres, who holds stock dividends as gains from his investments. The subsequent buyer who buys stock dividends is investing capital. It just so happen that what he bought is stock dividends. The effect of its (stock dividends) redemption from that subsequent buyer is merely to return his capital subscription, which is income if redeemed from the original subscriber.

After considering the manner and the circumstances by which the issuance and redemption of stock dividends were made, there is no other conclusion but that the proceeds thereof are essentially considered equivalent to a distribution of taxable dividends. As "taxable dividend" under Section 83(b), it is part of the "entire income" subject to tax under Section 22 in relation to Section 21 120 of the 1939 Code. Moreover, under Section 29(a) of said Code, dividends are included in "gross income". As income, it is subject to income tax which is required to be withheld at source. The 1997 Tax Code may have altered the situation but it does not change this disposition.

EXCHANGE OF COMMON WITH PREFERRED SHARES

Exchange is an act of taking or giving one thing for another involving reciprocal transfer and is generally considered as a taxable transaction. The exchange of common stocks with preferred stocks, or preferred for common or a combination of either for both, may not produce a recognized gain or loss, so long as the provisions of Section 83(b) is not applicable. This is true in a trade between two (2) persons as well as a trade between a stockholder and a corporation. In general, this trade must be parts of merger, transfer to controlled corporation, corporate acquisitions or corporate reorganizations. No taxable gain or loss may be recognized on exchange of property, stock or securities related to reorganizations. 

Both the Tax Court and the Court of Appeals found that ANSCOR reclassified its shares into common and preferred, and that parts of the common shares of the Don Andres estate and all of Doña Carmen's shares were exchanged for the whole 150.000 preferred shares. Thereafter, both the Don Andres estate and Doña Carmen remained as corporate subscribers except that their subscriptions now include preferred shares. There was no change in their proportional interest after the exchange. There was no cash flow. Both stocks had the same par value. Under the facts herein, any difference in their market value would be immaterial at the time of exchange because no income is yet realized — it was a mere corporate paper transaction. It would have been different, if the exchange transaction resulted into a flow of wealth, in which case income tax may be imposed.

Reclassification of shares does not always bring any substantial alteration in the subscriber's proportional interest. But the exchange of shares is different — there would be a shifting of the balance of stock features, like priority in dividend declarations or absence of voting rights. Yet neither the reclassification nor exchange per se, yields realize income for tax purposes. A common stock represents the residual ownership interest in the corporation. It is a basic class of stock ordinarily and usually issued without extraordinary rights or privileges and entitles the shareholder to a pro rata division of profits. Preferred stocks are those which entitle the shareholder to some priority on dividends and asset distribution. 

Both shares are part of the corporation's capital stock. Both stockholders are no different from ordinary investors who take on the same investment risks. Preferred and common shareholders participate in the same venture, willing to share in the profits and losses of the enterprise. Moreover, under the doctrine of equality of shares — all stocks issued by the corporation are presumed equal with the same privileges and liabilities, provided that the Articles of Incorporation is silent on such differences. 

In this case, the exchange of shares, without more, produces no realized income to the subscriber. There is only a modification of the subscriber's rights and privileges — which is not a flow of wealth for tax purposes. The issue of taxable dividend may arise only once a subscriber disposes of his entire interest and not when there is still maintenance of proprietary interest. 

WHEREFORE, premises considered, the decision of the Court of Appeals is MODIFIED in that ANSCOR's redemption of 82,752.5 stock dividends is herein considered as essentially equivalent to a distribution of taxable dividends for which it is LIABLE for the withholding tax-at-source. The decision is AFFIRMED in all other respects.